Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory for companies for tax purposes. They are also used by managers to assess the performance of the business.
Together those three documents make up what is usually referred as “financial statements.”
Each of these statements has a different purpose and together they give us specific information in regard to: “Return, Risk, and Cash”.
First, if you look at the income statement, there is no way you would make any assessment about the risk of the organization at that particular point in time or the cash produced in a certain period.
Instead, the Income Statement (or Profit & Loss) will show you the return generated by the business.
Second, if you want to understand how an organization acquired the resources to operate the business, you have to look at the Balance Sheet.
How does the balance sheet assess the risk of an organization?
Simple, there are two ways a company can acquire resources:
either through Equity or Debt.
As you can imagine, too much debt can be dangerous. What would occur if you run a business and suddenly your creditors ask for the money you owe them?
You would go bankrupt. Instead, when debt in proportion to the equity is dismal, this makes your organization creditworthy and safer.
Third, it happened many times in the financial world history to see profitable companies bankrupt due to poor cash management.
The cash flow statement helps you to answer questions such as: How much cash did we make? Where did the cash come from?
In fact, an organization can find cash through three main activities: Operating, Investing, and Financing.
Income Statement (P&L): Show me The Bottom Line
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at a fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at a profit or loss (also called the P&L statement).
The main purpose of the income statement is to show the return of the business in a certain period: Quarterly, Biannually, or Yearly.
The income statement is built around the bottom line, the “net profit”. Do not be surprised to notice your eyes unexplainably falling on the net income.
This distracts you from other metrics on the Income Statement that are as important as the Net Income.
Balance Sheet: The Power Of The Now
The accounting equation is the fundamental equation that keeps together a balance sheet. Indeed, it states that assets always equal liability plus equity. The foundation of accounting is the double-entry system which assumes that a company’s balance sheet can be broken down into assets, and how they get sources (either through equity/capital or liability/debt).
The main purpose of the Balance Sheet is to show the risk of the business in the particular moment you are looking at it.
In Fact, if you look at the balance sheet on January 1st it won’t be the same on January 2nd.
Of course, this is true for the P&L and CFS (Cash Flow Statement) as well, but the balance sheet is an instant snapshot of the business more than a collage of pictures taken in different moments, like the Income Statement.
Cash Flow Statement (CFS): Cash Is King
The cash flow statement is the third main financial statement, together with the income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing, and financing. The cash flow statement can be prepared with two separate methods: direct and indirect.
The main purpose of the cash flow statement is to show the cashgenerated by an organization in a certain period: Quarterly, Biannually, or Yearly.
It doesn’t matter how much profits a business is making, one way to know whether the business will survive in the next future is to look at the cash.
Generating cash is no easy task and the organizations who are able to keep their profits stable and generate enough cash to sustain their operations and invest for future growth are the ones who thrive.
Real Life Analogy
Let me use a real-life analogy here. If you are a photographer in order for you to do your job, you must have a professional camera.
In addition, you can take instant pictures or build a collage of pictures you have taken in the last three months, and remember the camera will work as soon as the battery will be charged.
Indeed, you can compare the single picture or “instant picture”, on your balance sheet, while the “collage” pictures taken in the last three months, are on your income statement.
Furthermore, you want to see what’s the level of charge of the battery and how long the camera will operate. The battery life can be compared to your cash flow statement.
Indeed, a lack of cash for a business is almost like a lack of oxygen for an individual.
According to your needs, you can look separately at each statement.
However, if you want the whole picture of the business you must look at all of them concurrently.
The accounting equation is the fundamental equation that keeps together a balance sheet. Indeed, it states that assets always equal liability plus equity. The foundation of accounting is the double-entry system which assumes that a company’s balance sheet can be broken down into assets, and how they get sources (either through equity/capital or liability/debt).
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at a fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at a profit or loss (also called the P&L statement).
The cash flow statement is the third main financial statement, together with the income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing, and financing. The cash flow statement can be prepared with two separate methods: direct and indirect.
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowments from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed assets, with a long-term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.
The cost structure is one of the building blocks of a business model. It represents how companies spend most of their resources to keep generating demand for their products and services. The cost structure together with revenue streams, help assess the operational scalability of an organization.
Economic or market moats represent long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.
The gross margin is a financial ratio metric, which helps assess the profitability of a business and also its operational efficiency. Indeed, as gross margins take into account the cost of goods sold (the cost incurred to deliver the software to the customer) it’s a measure to assess the value of a business.
The profit margin is a profitability financial ratio, given by the net income divided by the net sales, and multiplied by a hundred. That is expressed as a percentage. That is a key profitability measure as combined with other financial metrics, it helps assess the overall viability of a business model.
Gennaro is the creator of FourWeekMBA, which reached about three million business students, executives, and aspiring entrepreneurs in 2021 alone | He is also Head of Enterprise Sales for a high-tech startup, which he helped grow at a double-digit rate since the onset | In 2012 Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
